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Negative interest rate: How it works

When interest rates go below zero, you lose money.

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Ryan Brinks
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Normally, when you deposit your money into a bank account, the bank pays you interest on your deposit. Negative interest rates are the opposite — depositing money attracts a fee, but you get discounts when you borrow.

What's in this guide?

What is a negative interest rate?

A negative interest rate refers to a rare situation in which interest rates dip below zero in response to economic instability. When this happens, it affects borrowers and savers in different ways. For borrowers, a negative interest rate (APR) means receiving interest on a loan, rather than paying it to your lender. And for savers, a negative interest rate (APY) means paying interest to your bank instead of earning interest on your savings.

National interest rate averages tend to fluctuate in line with the federal funds rate. This rate, which is set by the Federal Reserve, dictates how much banks or other financial institutions earn when lending money to each other on an overnight basis. If the Fed sets this rate below zero, your personal bank or lender then determines the exact rate you’ll earn on your loan or owe on your savings.

When a negative interest rate is in effect, it’s harder to save money but cheaper to spend it. In this way, negative interest rates can stimulate unstable economies.

How do negative interest rates affect me?

Right now, it probably doesn’t. While commercial banks get to decide what interest rates to offer customers, those rates are usually based on the federal funds rate set by the Federal Reserve. Interest rates dropped to nearly zero in 2008 in response to the Great Recession, and they fell again in 2020 from 0.09% to 0.04% due to the COVID-19 pandemic, but interest rates have never dropped below zero in the US.

However, some economists think that it’s time to jump on board with the growing global trend. Pushing interest rates into negative territory could induce more spending and borrowing, stimulating the economy. Implementing a negative interest rate is an attempt to inject more liquidity — more cash — back into markets and ward off deflation.

Why do negative interest rates exist?

Since the Global Financial Crisis (GFC) the world’s understanding of finance has changed rapidly. One idea that has emerged from the GFC is implementing negative interest rates. Negative interest rates are incentives for banks. The bank holds reserves and these are taxed by the negative interest rate, so the bank has higher incentives to lend out its reserves.

A few countries have said goodbye to zero interest rate policies (ZIRP) and hello to negative interest rate policies (NIRP). Switzerland was one of the first countries to implement NIRP in the 1970s in an attempt to deter a flood of foreign investment.

Benefits and risks of negative interest rates

Depending on how you look at it, a negative interest rate could be beneficial or detrimental to your finances. Here’s a look at the benefits and risks.

Benefits

  • Lower mortgage rates. A negative interest rate would make buying a home more affordable.
  • More affordable loans. You would pay less interest for personal loans, auto loans and small business loans.
  • Lower credit card rates. Credit card interest rates would drop if the Fed declared a negative interest rate, but your APR wouldn’t go below zero.

Risks

  • No return on your savings. You could be penalized for saving money by paying a “storage fee” that outweighs any interest you’d earn.
  • It may not help. Some European countries have instituted negative interest rates to stimulate their economies, but the results have been mixed.

Has there ever been a negative interest rate in the US?

No. Interest rates have dropped as low as 0.04% on a few occasions during the past decade, and yields on some short-term Treasury bills and government bonds in Europe and Japan have previously sunk into negative territory, but the federal funds rate has always been positive.

America’s financial stability

The US banking system continues to benefit from strong overall asset performance. Rising home prices have forced more mortgage lending, which is particularly important to banking stability. Interest rates in the country have also risen as the economy has started to recover from the Global Financial Crisis. However, if they dip back down in the future, the Federal Reserve could decide to implement a negative interest rate. If they did, it would be up to your bank to decide whether or not charge its own negative interest rates.

Which banks have implemented a negative interest rate policy?

Following the Global Financial Crisis, some centralized banks outside of the US experimented with negative interest rates, including the:

  • Bank of Japan
  • Swedish Riksbank
  • Swiss National Bank
  • Danmarks (Denmark’s) Nationalbank
  • The European Central Bank

However, none of these bank’s regions achieved measurably improved economic performance due to the implementation of a negative interest rates.

Bottom line

A negative interest rate could be a way to stimulate the economy, but so far it isn’t something we’ve tried out in the US. Economists are divided over whether or not it would be a good idea — it would encourage spending and inject cash into the market, but it would also make it more difficult for people to save. That being said, even if the federal funds rate dips below zero in the future, there’s no guarantee that banks would pass those savings on to you. To earn the most interest on your money, check out our picks for the best high-interest savings accounts.

Picture: Shutterstock

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